a situation where two different entrepreneurs bought

an identical asset, in this case it was a pizza parlor or

a pizzeria, but they each financed it

in a different way.

This guy was a little bit more conservative.

He paid for it outright.

The entire asset was his equity.

He had no debt.

While this guy, he borrowed some money and he even had

some non-operating assets.

So he levered up.

For every $1 he put in he borrowed $10 from the bank in

order to buy more assets that he actually

brought to the table.

And we saw when you did their financial statements-- their

revenue, cost of goods-- everything up to the operating

profit line was the same.

And that makes sense because, if you remember the first

introduction to income statement video, operating

profit is really indicative of what the operating assets are

generating.

So in this case it's what this purple area right here is

generating.

You could also consider that the enterprise.

What the enterprise is generating.

And everything below the operating line, everything

below the operating profit line, is either coming from

non-operating assets, that would the case of

non-operating income.

And the entrepreneur on the right had some of that.

He had some of this non-operating income, $2,000

per year in that case.

While this guy didn't have any.

And then you have expenses associated

with interest. Right?

In this case this entrepreneur had 5% of

$100,000, so $5,000 a year.

And then when you have these differences in capital

structure it changes what your net income is.

And they have slightly different net income numbers.

But what we saw is when we applied the same price to

earnings ratio, and they had the same share counts-- I

didn't change too many variables here I just really

changed how they paid for the asset.

But when you apply the same price to earnings ratio to

both earning streams, to both companies, you got something

that was reasonably unintuitive.

And there's no trick here really.

Because it's not crazy to assign the same price to

earnings ratio.

And if you try it out, if you grow this guy's revenue a

little bit, if you actually grow both of their revenues by

the same amount or both of their gross profits by the

same amount or if you grow both of their operating

profits by the same amount, you're actually going to see

that this guy's earnings per share is growing faster.

So given that someone might say, oh, because of the

leverage maybe I'm willing to pay even a higher multiple.

So it's not crazy to pay the same multiple for both of

these guys.

But we saw at the end of the last video, when you apply,

let's say, a 10 multiple, or really any multiple to both of

these earning streams, you get a situation that at first

doesn't look crazy.

OK, the market cap of this guy is $210,000 if you apply a 10

multiple to their earnings stream, while the market cap

of this guy is $189,000 if you apply a 10 multiple to their

earning stream.

Right?

10 times 18.9 thousand is 189,000.

10 times 21 thousand is 210,000.

But what was the conundrum, what really got us thinking,

was how can this whole equity stream right here, or this

equity, or this earnings stream be, worth 210 and this

one be worth 189 when this guy only put $10,000 in initially

and this guy put $100,000?

He put in 10 times as much.

And so when you're paying $210,000 for this asset, for

this equity, you are essentially saying that this

asset is worth $210,000.

But if you're saying that this equity is worth $189,000,

right, that's what the market cap is.

It's the value of the equity.

Then you're implicitly saying that this asset, that all of

these assets are worth the value of this market

capitalization plus this debt, right?

So that's $289,000.

And then if you wanted the value of this operating asset

you would subtract out this much right here, the cash.

So you got something like $279,000.

So when you apply the same price to earnings to to these

similar businesses you've actually got a situation where

you're overpaying for this asset relative to this one,

even though they're identical.

So that left us with a question: what do we do?

What can we use other than a price to earnings ratio?

And that's what this video is for.

So the short answer is, one, you do have to

use something different.

Price to earnings ratio is a good a quick way of comparing

two companies relative to their growth or

relative to an industry.

But it does lose a lot of information relative to how

the companies are capitalized.

You saw in the last video that how you're capitalized, and

when I say capitalized I mean how do you

pay for your assets.

If you have a lot of debt versus a lot of equity, what

actually happens on the earnings line

is very, very different.

And so you lose all of that information.

And so if you want to capture that information, when you

look at the price of a stock you have to figure out what

you're actually paying for the enterprise of the company, the

enterprise value of the company.

So when I talk about the enterprise, or the enterprise

value, I'm talking about the operating assets.

It gets a little bit more complicated if you're talking

about a financial company like a bank or

an insurance company.

But if we're talking about a widget factory, the enterprise

is essentially the assets.

The enterprise value is the asset value of the assets that

allow the company to do business.

So whatever factories-- well, in this case it's a pizzeria,

so the ovens, the building, the places, where people

actually eat their food, and even the cash that's necessary

to operate the business.

The enterprise value shouldn't incorporate the cash that's

surplus, that's not necessary to operate the business.

So that begs the question, how do you calculate the

enterprise value?

So you could go backwards and you say, OK, for a given price

how much am I paying for an enterprise value?

So let's say that this stock-- let's say that Company A or

this one, let's say the stock right now is trading at $20.

So this is the current price that you could buy it at.

So it's the asking price in the market is at $20.

While this one is at, let's say it's at $10.

It's at $10.

So at first glance you might just do a quick price to

earnings ratio.

And you'll say, OK, for $20 I'm getting $2.10 earnings per

year, assuming it's not growing or something.

So my price to earnings is approximately, I don't know

have my calculator in front of me, but $20 divided by $2.10

is going to be 9 point something, something.

Right?

While this guy, for $10, I am getting $1.89 of

earnings per year.

So what's 100 divided by 18?

It's 5 or 6 times.

It's going to be 5 point something.

6 times 18 is 60 plus -- Yeah it's going to be 5 point

something, something.

So when you superficially just look at this you're going to

say, wow, this is a cheaper price to earnings ratio, maybe

I should buy that.

But what we saw in the last video is that price to

earnings isn't a good relative valuation metric when two

different companies are capitalized very differently.

So what you want to do is instead back out what these

prices imply about the enterprise value.

So what does $20 imply about the enterprise value and what

does $10 imply.

And how do you do that?

Well first you say what is the market cap?

Market cap.

So you take the price times the number of shares.

If you remember, we had 10,000 shares.

So in this case $20 times 10,000 shares implies a

$200,000 market cap.

In this case we have $10 times 10,000 shares so it implies a

$100,000 market cap.

Now remember, the market cap is just what's left over.

So let me redraw those two diagrams because I feel like

I'm--

So for this entrepreneur you have the assets

and there's no debt.

So the assets are kind of completely

represented by the equity.

So if the market cap is $200,000 you're essentially

saying that these assets, these operating assets, are

worth $200,000.

So in this case, at a price of $20, we know that the

enterprise value, the market enterprise value, so what the

market is saying the enterprise is worth, the

operating assets are worth, is $200,000.

Now, in this case, remember the market is saying that the

equity is worth $100,000.

Let me draw that.

The market is saying that the equity is worth $100,000.

But of course this company has a lot of debt.

It has another $100,000 of debt.

Actually let me draw this a little bit different.

All right.

So in this situation the market is saying that its

market cap is $100,000.

So just to be proportional let me draw it like that.

Not really use that one.

So $100,000, this is the equity or the market

capitalization or the market value of the equity.

That's what the market cap is.

So that's just the price times the number of shares.

And then it has debt.

If I remember correctly it has $100,000 in debt.

We take $100,000 in debt.

$100,000.

And so what is it saying about the assets?

So the equity plus the debt, or the

liabilities, is $200,000.

So it's saying all of the assets are worth $200,000.

This is all of the assets, $200,000.

But what we need to do, we want to figure out the value

of the enterprise.

Not just all of the assets.

So if we remember there was some of the assets that were

actually operational and some were non-operational.

So we had $10,000 of cash right there.

So we have $10,000 of cash.

So when this stock is trading at $10 it implies a market

capitalization of $100,000.

It implies that the liabilities

plus equity is $200,000.

So all of the assets are $200,000.

But if we were to subtract out the cash or the non-operating

assets, what's not necessary to operate the business, we

get $190,000 of enterprise value.

So in this case we're saying that the

enterprise value is $190,000.

So in this case, when you look at the price to earnings

you're like, wow, this is half as expensive as that.

This is great deal, let me buy it.

And I just happened to make up the numbers so even when I did

the enterprise value it's only 5% cheaper.

Here it looks 50% cheaper.

Here it looks 5% cheaper.

And so it might be a little unintuitive.

To figure out the enterprise value you take, and this will

be the formula you see in a lot of books.

Enterprise value is equal to market cap

plus debt minus cash.

And you might be like, when I'm trying to value something

why should I add debt back?

Debt is a negative thing.

Shouldn't debt make my enterprise worth less?

And why am I subtracting cash?